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Three Trends and a Train Wreck

HOW did the world’s financial system get into such a mess? It’s tempting to blame specific politicians, decisions and laws (or the lack thereof), and leave it at that.

While it’s certainly true that a great number of serious, identifiable mistakes have been made, we need to broaden our thinking in order to understand what has happened.

The crisis is global in nature and its causes are more general and less country-specific than is commonly reflected in the political discourse of any single nation. Many countries — not just the United States — came to have fundamentally unsound banking systems. If Japan remains an exception, it is only because it already suffered through similar problems in the 1990s.

The current financial crisis comes from a conjunction of three major trends, common to many countries and to a wide variety of financial institutions.

The first trend was a positive one: an enormous growth in wealth that needed to be moved into investments. Before he became chairman of the Federal Reserve, Ben S. Bernanke wrote of a “global savings glut,” particularly from Asia. Furthermore, over the last 20 years, many countries have modernized their financial systems and created new channels that linked savings and investment. In Spain, Iceland, Ireland and Britain, the real estate boom was without recent precedent.

Of course, more wealth is a good thing over all, but the question is whether that wealth has been invested in an effective and prudent way.

This leads us to the second trend, the greater willingness of both individuals and financial institutions to take on risk. This trend has shown up in many areas, including real estate, derivatives markets, loans to companies like the American International Group, and overpriced equities. Heavy debt, particularly in financial institutions, created a low margin of error for many of these calculations.

Greater risk-taking was driven by investor hubris and collective delusion. Banks and other financial institutions bet against the possibility of bad times and in the short run those bets paid off handsomely. But in the long run they were disastrous.

For a simple analogy, imagine betting against a sports underdog every year. You may win consistently for a while but eventually you will lose all your money when the odds turn against you. In essence, banks were betting against extreme volatility, which sooner or later does arrive.

Photo

Credit
David G. Klein

In the United States, loose monetary policy in the previous decade encouraged this misplaced optimism, while in Europe there was giddiness from the benefits of economic integration. People pursued profits rather than prudence because their minds and emotions were geared to expect further rewards.

The third component has been weak governance and oversight. That includes inadequate control and monitoring by shareholders, regulators, creditors, accounting systems and ratings agencies, among others. Most people, including informed insiders, simply did not understand the systematic risk that financial institutions were accepting.

A common view was that a real estate bubble had popped before — in the late 1980s — and that the United States had survived that event with a mild recession but not much calamity. Yet, in the meantime, the world had created more fragile interconnections through debt, while most people’s expectations about risk had stood still.

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The end result was that both markets and governments failed miserably — at the same time and on the same issues. With hindsight, it is easy to argue that regulation should have done more, but in most countries, governments were happy about rising real estate and asset prices and didn’t seek to slow down those basic trends. (You’ll note that greed doesn’t play an independent role in this explanation because greed, like gravity, is pretty much always there.)

Subprime loans collapsed first because those were the investments most dependent on relatively poor borrowers who were the most likely to fail. Since then, we’ve seen asset values fall throughout the economy. Subprime borrowing was the canary in the coal mine, but it was hardly the only problem. It now seems that a wide range of asset prices were artificially inflated. The market for contemporary art, which depends almost exclusively on very wealthy buyers, will probably be the last market to plummet but that development is almost certainly on its way.

Over all, then, the three fundamental factors behind the crisis have been new wealth, an added willingness to take risk and a blindness to new forms of systematic risk. All three were needed to bring about the scope of the current mess — so that means we’ve had some very bad luck on top of everything else.

One prophet of today’s crisis was Fischer Black, the late financial economist who developed the Black-Scholes formula for options pricing with the Nobel economics laureate Myron S. Scholes. Mr. Black died more than a decade ago and his work on macroeconomics has not received much attention recently. But in his 1991 book, “Business Cycles and Equilibrium,” and his 1995 work, “Exploring General Equilibrium,” he argued that major business downturns could be caused by a combination of excess risk-taking and simple bad luck.

Most business-cycle analysts have very detailed scenarios for how things go wrong, but Mr. Black’s revolutionary idea was simply that we are not as shielded from a sudden dose of bad luck as we might like to think.

WE’VE already been through a savings and loan crisis, a junk bond crisis and a dot-com bubble, but today’s crisis is by far the worst of the lot — and will probably prove to be more than just a bump in the road. We can do better the next time around, but we have to start by seeing that the current failure is far-reaching and that we can blame many different things and many different people.

The real problem is not some particular villain but rather the very fact that we cannot help but put the evaluation of risk into all-too-human hands.